The Tax Benefits of Commercial Property
By Nick Braun MSc PhD
More and more property investors are turning to commercial property - shops and offices typically - to diversify their buy-to-let portfolios.
The main attraction is the secure income stream that comes from having high-quality tenants on long leases. Can you imagine anything more cushy than owning an office block with a government organisation as the tenant on a 25 year lease? Certainly beats having a bunch of students ransack your flat and push off after 12 months.
And because commercial property tenants are usually responsible for most of the expenses, such as repairs and insurance, you can potentially just sit back and watch the money roll in.
Of course, it's never that simple. Investing in commercial property is a totally different ball game to investing in residential property and requires a certain amount of specialist knowledge.
However, more and more traditional buy-to-let investors are successfully making the transition and reaping the rewards. I met quite a few at the recent Property Investor Show in London.
If you are interested in taking the plunge you have to do some homework. The best way is to read as much about commercial property generally before you even begin to look at specific investment opportunities. To help out I've compiled a list of some useful resources at the end of this article.
And what about the tax benefits of commercial property investment? As you'll see in the paragraphs that follow, the taxman certainly seems to have a soft spot for this type of investor.
The Tax Benefits of Commercial Property Investment
One of the biggest decisions any property investor must make is how to invest, in other words using what legal structure. A commercial property investor can invest in one of four ways:
- Personally, in other words in your own name
- Using a company
- Indirectly via an ISA
- Through a self-invested personal pension plan(SIPP)
The tax implications of each are potentially enormous. Let's take brief look at each in turn:
Most investors do it this way: they buy property personally/directly rather than use another legal structure.
(Note, limited partnerships are an increasingly popular way of pooling funds with other commercial property investors. However, these are taxed in exactly the same way as direct investments.)
The advantage of investing in commercial property directly is that when you sell up you may qualify for special capital gains tax treatment.
For a detailed description see Carl Bayley's book How to Save Property Tax but the basic idea is you will qualify for 'business asset taper relief'. This means three quarters of your profits will be completely tax free after just two years.
This makes commercial property one of the best capital gains tax shelters around. Effectively you can never pay tax at more than 10%. In many cases, thanks to the added benefit of your annual capital gains tax exemption, you will pay tax at an even lower rate.
Unfortunately when it comes to claiming the special capital gains tax treatment there is one big 'BUT'. You will not qualify for business taper relief if your property is let to a quoted (ie stock exchange listed) company such as Marks & Spencer.
And let's face it, you'd much rather have a large quoted company as a tenant than, for example, Loopy Lucy's Incense Emporium.
At least you can be pretty sure a large high street store will still be in business in five years' time and able to honour your lease. That's the whole reason people invest in commercial property after all: to earn a reliable long-term income. Loopy Lucy may however be insolvent after 12 months.
If you let your property to a quoted company you will only qualify for the much more stingy non-business asset taper relief. This type of taper relief only exempts 5% of your profits after three years and 40% after a decade.
Should you choose an unquoted tenant over a quoted tenant to ensure a potentially much lower tax bill? Most certainly not!
As we try and stress in all our tax guides, saving tax is important but it's much more important to make money in the first place.
And what about the rental income? After all many commercial property investors are more interested in earning income than achieving capital growth.
Unfortunately there's no concession here. You'll pay income tax at 22% or 40% based on whether you're a basic-rate or higher-rate taxpayer. To protect your rental income you have to consider investing in a different way.
Using a Company
A lot more investors are using companies these days for the simple reason that corporation tax rates are much lower than personal tax rates.
For a more detailed look at using companies see Carl Bayley's definitive guide: Using a Property Company to Save Tax.
If you invest through a company you may be in the opposite position to the personal investor: you will pay less tax on your rental income but more tax on your capital gains.
For example your rental profits may be taxed at rates as low as 0% which is great news for commercial property investors with high-yielding properties.
For example, if you earn rental profits of £15,000, the first £10,000 will be completely tax free and the remaining £5,000 will be taxed at 23.75% -- a total effective tax rate of just 8%!
There's extra tax to pay if you extract dividends but if you can afford to keep reinvesting your profits for many years, a company could prove an extremely powerful tax shelter.
However, it's important to remember that companies don't qualify for taper relief when they sell property so the generous business taper relief which shelters three quarters of a direct investor's commercial profits, will not be available.
Instead your company will qualify for an indexation allowance which will simply protect you from paying tax on inflationary profits - about 3% per year at most.
You will personally qualify for taper relief if you sell your shares rather than the property itself. However, this will be at the reduced non-business taper rates.
The only way to escape income tax and capital gains tax (and corporation tax) is to invest through an ISA or self-invested personal pension plan.
Using an ISA
At present you can invest £7,000 per tax year in an ISA and not pay any income tax or capital gains tax on your investment profits.
The problem is you generally cannot use ISAs to invest in property. There are, however, a couple of exceptions.
Using a Self-invested Personal Pension
ISAs are a fantastic tax shelter but your investment choices are extremely limited.
One way of having greater investment choice and flexibility is to buy commercial property through a self-invested personal pension SIPP).
The advantage of investing through a SIPP is that you pay no income tax or capital gains tax on you rental income and capital gains.
More important, however, you also receive tax relief on any contributions you make into your pension account.
This effectively means that you will be able to buy property at a 40% discount.
Commercial property SIPPs are extremely popular with business owners who use them to buy premises for their companies. Your company would then pay rent to your SIPP. The company would claim this expense as a tax deduction and the SIPP would pay no tax on the rental income it receives.